Note November 7, 2017: Minding the gap of expectations and credibility has been a market issue that has flared multiple times, not least when investors are lulled about risk. Operational changes need to be monitored at several central banks, including at the Federal Reserve despite the aura of continuity in new leadership from February 2018. Absent currently active vigilantism, the derivative impact of government budgets and deficits has been under addressed in the pricing of fixed income. It makes any credibility gap in a momentum market all the more significant especially if reports are accurate of the widespread use of leveraged fixed income holdings in order to boost yield. Fee slicing in ETFs could have the side effect of extenuating lurches in capital markets.
Even with a paucity of index corrections in the equity markets, rotation has been instructive amid predispositions already of reacting after the fact especially on adverse operational performance. In classical late cycle fashion, on more confidence about global growth with the antecedent of that in the U.S., small capitalization equities and global equity indices did pick up relative performance. Now, even as the S&P 500 and DJIA indices set records into November 6, 2017, subsequent relative slippage such as in U.S. small capitalization indices has appeared. Even more so, expanded volatility and similar relative performance slippage could presage change. An ancillary effect of the current price war in ETF fees may have made equities even more susceptible to herd behavior.
These sequential developments do not absolve investment assessments from taking valuation into account versus the credibility of expectations. So does the ongoing evolution of operational and financial restructuring of companies at large. Reported results are emerging in an earnings cycle that likely is in a slower expansion phase, after the cyclical recovery that started from 2009 to 2016. They show bifurcation not just in consumer areas as spending patterns change but even in energy experiencing recovery in crude oil pricing. We believe quality of operations and financial structure is broadly important in investment selection. Also with many businesses having undergone severe restructuring, we assess current exposure to commodities (precious metals, energy, metals) as attractive for hedging and likely even more so, were inflation to rise above the 2% that many central banks aspire towards.
Plausible expectations being driven to excess have often been the bane of markets. Minding the gap in terms of expectations and credibility remains an issue that can flare up unexpectedly. It has been so several times and not least when investors are lulled about risk. In paucity currently, flaring of concern has taken place previously in the form of more rapid corrections that refresh but more occasionally also via market debacles like the valuations crunch of the 1970s or the October 1987 crash on arbitrage mismatch or the technology concept implosion of 1999/2000 or the credit liquidity debacle of 2007/8. Presently in minding the gap between expectations and credibility, operational changes need to be monitored at several central banks, including at the Federal Reserve. Also crucial is monitoring the urgency for companies at large of competition forcing operational restructuring as well as evolution in financial restructuring. Far removed now in the pricing of fixed income has been its prior laudable roles of vigilantism. The derivative impact of government budgets and deficits has currently been under addressed. It makes any credibility gap in a momentum market all the more significant. Further, fee slicing in ETFs could have a side effect of extenuating lurches in capital markets that are already predisposed to momentum. Across capital markets, we believe quality of operations and financial structure are important in investment selection, despite low interest rates. With many businesses having undergone severe restructuring, we assess current exposure to commodities (precious metals, energy, metals) as attractive for hedging and would likely be even more attractive were inflation to rise above the 2% that many central banks aspire towards.
Amid the herding that engulfed central banks around massive quantitative ease over 2008-16, change did have a hiatus as a tool of policy. Now, differing policy steps of change have appeared on implementing regulation. At various levels, the central banks have faced down concerted industry pushback over Basle III and the importance of bank capital strengthening. In another development in jurisdictions as disparate as Germany, India and China among many others, despite pushback from political quarters, there has emerged a new cycle of impaired loan recognition and of concomitant capital strengthening. Revised stress tests have been raised as possible. With the exception of Japan, significant change in monetary policy itself is also evolving. Even with a 7-2 vote and despite the Bank of England rate being at only 0.5% (compared to 5.75% in August 2007), its 25 basis point increase on November 2, 2017 and commentary of the potential for more hikes were noteworthy in that they occurred despite the imbroglio that Brexit appears to have muddled into. Immediately prior, the European Central Bank may not have raised rates but it did send out important signals in announcing potentially cutting monthly balance sheet purchases from Euro 60 billion to Euro 30 billion from January 2018. The ECB now appears in genteel variance from its hot “all it takes” rhetoric of a half decade ago.
Although outside of theoretical economic circles, the announcement of a new Federal Reserve Chairman on November 2017 appears as not being of the change magnitude of policy or operational as was that of August 1979. Despite the aura of continuity in new Fed leadership from February 2018, markets can be expected to be watchful and even testing likely – an aspect normal prior to 2007 but ostensibly forgotten today. Many Fed positions remain to be filled into 2018 with impact on future policy, including Deputy Chairman of the Fed and now also the head of the New York Fed. Still, the significance remains intact of the Fed stance already unveiled of ongoing rate increases to we believe to 3.50% by Q1/2019 and of impending shift of quantitative ease from purchases to current neutrality and then upcoming into sales, leading to contracting of the Federal Reserve Balance sheet by as much as $2.5 trillion from its present $4.5 trillion. The pricing of fixed income has been far removed now from its laudable role of vigilantism before. The derivative impact of government budgets and deficits has been under addressed currently. Investment portfolios also appear to have been able to slough off increases in 10 year Treasury Note yields from lows of 1.36% to the present 2.31%. We expect performance pressure points to ratchet sharply up as changes extend into risk premiums. It would be especially true in this cycle if reports are accurate ofa widespread use of leveraged fixed income holdings in order to boost yield. When it comes to corporate capital budgeting, it can also be expected to translate into renewed focus on leverage risk and raise scrutiny of the stability of equity valuation. Across investments, such aspects contribute to us favoring quality of delivery in corporate operations and in financial structure.
Even with the lack of overall index corrections, rotation in the equity markets themselves has been instructive. It is taking place amid a flood of oft massaged messaging that has become part of the corporate reporting process. Overall, bifurcation of results within industries remains present whether in industries emerging from restructuring like energy or in industries like consumer areas facing a sharply changed customer that nonetheless has money to spend. Bifurcation appears still in finance that is cushioned in very low interest rates or for that matter in information technology that, in contrast to 1999/2000, otherwise appears demonstrating less concept and more delivery of operating results amid growth. Markets remain in momentum mode and unlike the give and take of earlier cycles, appear more predisposed to reacting after the fact especially on adverse operational performance.
As more confidence developed about global growth amid the antecedent of that in the U.S. in this cycle, more classically than generally recognized, small capitalization equities and global equity indices did start to pick up performance from U.S. indices. It has been a typical late cycle phenomenon. Still, even as the S&P 500 and DJIA indices set records into November 6, 2017, subsequent relative slippage has appeared in areas such as U.S. small capitalization indices. Expanded relative performance slippage and even more so expanded volatility could be salient indicators of change. It would be especially so as an ancillary effect of the current price war in ETF fees that may have made markets even more susceptible to herd behavior. Such developments do not absolve investment assessments from taking valuation into account versus the credibility of expectations, especially as quantitative ease policy as the primary driver of capital markets shifts. As economic growth expands and unemployment levels drop in many countries to hitherto low benchmarks, ongoing commentary on the paucity of inflation has emerged from central banks and in the markets themselves. As is typical about economics, these debates are likely to be long ongoing as production strategies evolve in business. We believe quality of operations and financial structure is important across investments.
Even as product and business restructuring in companies appear at a steady pace amid political change, it is noteworthy that despite mute inflation, price recovery has taken place in energy, in base metals and in precious metals – all having undergone prior restructuring stress. It is likely that were inflation levels to be effected to above 2% as is the central bank aspiration, further commodity price gains would unfold. These aspects mean commodities like metals and energy as well as precious metals offer an interesting hedges at present, as do derivatives ranged from companies with such resources to country exposure ( like Australia and Canada as well as those up much higher in risk profile including frontier areas like Africa). It would transcend traditional equity and fixed income portfolio allocations.